Tuesday, February 12, 2013

Lawrence H. White and William Luther have severalpapers on the fascinating case of Somalia money after the state collapsed in 1991. Here is an excerpt:

Over the last few decades, much work has focused on potential mechanisms to govern the supply of money in a desirable manner. Interestingly, a rough mechanism seems to have emerged naturally following the collapse of the Somali state in 1991. Without a functioning government to restrict the supply of notes in circulation, Somalis found it profitable to contract with foreign printers and import forged notes. Forgers were constrained since Somalis would only accept denominations issued prior to 1991; larger denomination notes could not be issued profitably. Although the exchange value of the 1000 Somali shillings note fell from $US 0.30 in 1991 to US$ 0.03 in 2008, the purchasing power eventually stabilized, as the exchange value equaled the cost of producing additional notes.

So even money forgers equate the margins: they continued to create counterfeit notes until the marginal cost of production equaled the marginal benefit. That is, the Somalia notes fell in value until they were worth no more than the paper, ink, printer, electric, shipping, and other costs required to make them. That sounds a lot like commodity money to me. And this led to a stable monetary environment for Somalia despite the failed state. This fascinating monetary experiment runs contrary to the common monetary history of commodity (or commodity-backed) money turning into fiat money. In Somalia, the government fiat money turned into private commodity money. I look forward to seeing what lessons JP Koning, the monetary historian of the blogosphere, draws from this experience.

Sunday, February 10, 2013

[T]he record shows that total federal governmentoutlays
were 25.2% of GDP in 2009, 24.1% of GDP in 2011, and 22.8% in 2012...Both outlays and receipts are, as a share of GDP, below
pre-crisis level... the "austerity" of 2011-2012 wasn't "austerity" but
austerity. Federal government spending fell by a meaningful share of GDP
over that period. So did federal government employment, which dropped
by 31,000 jobs in 2011 and 45,000 jobs in 2012. What's more, we have
good reason to believe that these cuts entailed positive multipliers
above those we'd observe in normal times. You don't have to take the IMF's word for it; even stimulus sceptics like Valerie Ramey find that multipliers may sometimes be above normal, and above one, during periods of economic slack.

This is exactly the case that I have been making. And apparently so has Goldman Sachs. The only additional point I have stressed is that despite this austerity happening at a time of high unemployment and a large output gap, a slowdown in aggregate demand growth has failed to materialize. This does not mean fiscal policy multipliers are small--they may be large--but only that the Fed has been offsetting the drag created by the fiscal austerity. And to boot, it has done so in an environment where the short-term interest rate is up against the zero-lower bound (ZLB). Monetary policy, therefore, is not out of ammunition at the ZLB, as I noted in my last post on this issue.

Just to be thorough, below are some figures that demonstrate the fiscal austerity observed by Ryan Avent. First, here is total federal government expenditures in current dollars. It has stalled and gradually started to fall:

As a percent of NGDP, total federal government expenditures is steeply falling. Not exactly a Keynesian prescription for stable aggregate demand when the economy is far from full employment:

If we look at the federal government deficit, whether in dollars or as a percent of GDP, it too indicates increasing fiscal austerity given the ongoing slack in the economy. Recall that running a deficit is how the government takes "idle" private-sector savings and puts it to "productive" work. Less and less of this transformation is being done:

Finally, if we look at those components that make up the "G" in GDP (i.e. Y=C+I+G+NX) in inflation-adjusted terms we see that G has been unequivocally falling:

Now this fiscal austerity is mild compared to what is proposed to happen going forward. But it is still fiscal consolidation and given large fiscal multipliers--which are more plausible in periods of significant economic slack like today--we should at least see aggregate demand faltering over the past few years while this unfolded. But in fact, we see relatively stable aggregate demand growth, as measured by NGDP:

This remarkably stable NGDP growth path since 2009 has occurred despite the fiscal austerity (and a host of other negative economic shocks like the Eurozone crisis, China slowing, debt ceiling talks, and fiscal cliff) and only makes sense if the Fed has been offsetting the fiscal drag. And again, it has been doing so in a ZLB environment. While the Fed's success here should be recognized, it is also apparent that the Fed has failed to restore NGDP to its pre-crisis trend. This failure to provide "catch-up" nominal spending growth is big black eye for the Fed and is why a NGDP level target is way overdue for the Fed.

Long-term government yields on safe assets across the globe have been declining since the crisis broke out. Something more than the Fed is at work (hint: think global economy buffeted by series of bad economic shocks). For more, see here and here.

Paul Krugman says now is not the time to cut government spending. Why? Because the Fed is out of ammunition and cannot possibly provide any offset to the fiscal drag such spending cuts would make:

Today, by contrast, we’re still living in the aftermath of the worst financial crisis since the Great Depression, and the Fed, in its effort to fight the slump, has already cut interest rates as far as it can — basically to zero. So the Fed can’t blunt the job-destroying effects of spending cuts, which would hit with full force.

The point, again, is that now is very much not the time to act; fiscal austerity should wait until the economy has recovered, and the Fed can once again cushion the impact.

There are two big problems with this analysis. First, fiscal retrenchment has already started and has been happening since mid-2010. The fiscal austerity train has already left the station and shocker of shockers, it has not caused the cataclysmic collapse in aggregate demand that Paul Krugman fears. Here is a figure from a earlier post that shows NGDP growth has been relatively stable despite the reduction in total government expenditures:

The same story emerges if one looks at the shrinking budget deficit. Note also that short-term interest rates have been near 0% since early 2009. So somehow the Fed has been able to keep NGDP growth stable despite (1) a fiscal contraction and (2) the zero lower bound on short-term interest rates. According to Paul Krugman this is not possible.

The second problem, then, with Krugman's analysis is his claim that the Fed is out of ammunition at the zero lower bound. He, of all people, should know this is not the case given his seminal work on Japan. He should also know this given all the exchanges he has had with Scott Sumner and me over the past few years. But just to be thorough, let me spell it out once again why the Fed is far from powerless.

To begin, consider how the public would respond if the Fed suddenly announced it was raising its asset purchase by 20% per month until some NGDP level target was hit. That would be the monetary policy equivalent of shock and awe and should catalyze the mother of all portfolio rebalancings. Households and firms would start spending their built up stock of money assets
on other riskier assets (like stocks and physical capital) as well as
goods and services in expectation of higher nominal income and temporarily higher inflation. Asset prices would increase, household balance sheets would be repaired, and real debt burdens reduced. This would reinforce the recovery in NGDP growth.

The key to this working is permanently raising the expected size of the monetary base. When this happens, expected nominal incomes will go up and lead to the responses outlined above. Thus, even though open market operations at the zero lower bound might be trading near substitutes now--monetary base for treasuries earning 0%--the belief that they won't stay near substitutes in the future (because of the permanent increase of the monetary base) will trigger the portfolio rebalancing that will lead to higher nominal spending.

Under QE1 and QE2 this did not happen precisely because the public did not expect the increase in the monetary base to be permanent, a point noted by Michael Woodford. But it has happened before. Back in 1933 FDR effectively took the reigns of monetary policy from the Fed and credibly committed to a higher monetary base level by devaluing the dollar. As consequence, the U.S. saw one of its sharpest recoveries that year. The same can happen now by adopting an aggressive, but well anchored nominal GDP level target.

Monday, February 4, 2013

John Cochrane has an interesting post where he considers the various reasons why consumption has failed to return to its trend path. One area where I disagreed with him was this statement:

"[A] more precise version of my first equation adds a "precautionary
saving" term. When people are very uncertain about the future, they save
more...This story seems possible for 2008 and 2009, in the depths of
the financial crisis and recession. But I'm less convinced that it
describes our current moment."

As I noted in his comments, it does seem strange to think that almost five years later precautionary savings would still be an important part of the story. But the data clearly shows that this is the case, as seen in the figure below. The blue line in the figure shows liquid assets (checking and cash, saving and time deposits, money market accounts, and treasuries) of households as a percent of total household assets. Now this indicator is really a measure of liquidity demand, but it gets at the same notion as precautionary savings. The red line shows the unemployment rate.

The figure indicates that liquidity demand rises before recessions and leads changes in unemployment. (Josh Hendrickson and I show in a paper that this indicator is systematically related to swings in aggregate nominal expenditures.) More importantly, this measure of liquidity demand still remains elevated to this day. So yes, precautionary savings (or precautionary demand for liquidity) still appears to be an important part of the ongoing slump.

Friday, February 1, 2013

Charles Goodhart has an Op-Ed in the Financial Times and a piece at VoxEu where he comes out swinging against nominal GDP level targeting (NGDPLT). He mistakenly thinks NGDPLT implies targeting real variables and having no long-run nominal anchor. He also thinks flexible inflation targeting (FIT) has been a smashing success so why abandon it now? Like you, I too am puzzled after reading these pieces. Surely Goodhart recognizes that NGDPLT is a money-denominated (i.e. nominal) target and that by definition it is bounded because it is a level target. If anything, it creates a firmer long-run nominal anchor than a "memory-less" FIT. And surely Goodhart is aware that the Great Recession in the United States and the Eurozone crisis occurred under the watch of FIT-type regimes. If FIT is so amazing then why has there been sustained drops in aggregate nominal expenditures in these two large economies?

It is especially surprising that Charles Goodhart can still be singing the praises of FIT after seeing what it has failed to do in the Eurozone. The figures below, which show the Eurozone less Germany, illustrate this point very clearly. The first one shows that the broad money supply (M3) has flatlined in this region.

Unsurprisingly, the flatlining of the broad money supply in the Eurozone less Germany region has led to NGDP that has flatlined too (after an initial drop).

If this is the best the Eurozone can do with FIT then maybe one should reconsider its viability, no? As alluded to above, it is not just that FIT is flawed, it is that NGDPLT is so much more than Charles Goodhart understands. Here is but one of his confusion over NGDPLT:

Adopting a nominal income (NGDP) target is viewed as innovative only by those unfamiliar with the debate on the design of monetary policy of the past few decades. No one has yet designed a way to make it workable given the lags in the transmission of monetary policy and the publication of national income and product.

Actually, only someone unfamiliar with the literature on "targeting the forecast" (see Lars Svenson and Michael Woodford) would make this outdated claim about lags. By targeting the forecast, a central bank manages expectations and operates with a lead. Big difference there. Needless to say, there is much more wrong about Charles Goodhart's NGDPLT critique and the untiring Scott Sumner lays out it here and here. [Update: See also the responses of David Glasner, Lars Christensen, Marcus Nunes, and Britmouse.] See here for why NGDPLT provides a strong nominal anchor.

P.S. Maybe Goodhart is simply confused about FIT's performance in the Eurozone. Maybe he has been talking to his German friends and generalizing from their experience. FIT seems to be working rather well for the German-portion of the Eurozone:

Update 1: Saturos nails it on the confusion of NGDP as a nominal variable.Update 2: The Economist swings back at Charles Goodhart and endorses NGDPLT for the UK.